Can the Fed Inflate the Money Supply at Will? My 2 Cents....

See here for the Mish/Ciovacco "debate" and RW's comments. The following is to explain the actual mechanics of what will likely happen in the near future.

James Bullard of the St. Louis Fed recently proposed via a research paper that the Fed resume quantitative easing. However, the FOMC is expected to announce next Tuesday that the Fed will merely reinvest its MBS cash flows in Treasurys. This is considered reserve-neutral (though most certainly not impact neutral).

The NY Fed's System Open Market Account, or the world's largest hedge fund as I like to call it, has $1.1 trillion in MBS outstanding. For simplicity, we'll ignore prepayments and say the average coupon is 5%. Therefore, $55 billion per year is being transferred out of the economy (and into the Fed) from people paying down their mortgages. M2 money supply as of July 26 is 8.556 trillion, so M2 is being deflated by 0.65% annually just as a result of this phenomenon, which is material when M2 growth has been anemic at under 2.5% for all of 2010.

The Federal Reserve Act allows the Fed to exchange maturing securities (Treasurys/Agencies/MBS) with the issuer (Treasury/Fannie/Freddie). However, it would be a violation to simply use MBS cash flows to purchase directly from the Treasury. Accordingly, the NY Fed will buy already issued T-Bills, Notes and Bonds from the 18 primary dealers through what are called permanent open market operations (POMO). This is where the NY Fed intentionally buys above market prices for securities to entice dealers to sell (or vice versa for POMO sales that soak up reserves).

While a dealer might acquire inventory from other institutions or the public for the specific purpose of selling to the Fed, most of the securities the Fed buys will be from the dealers' unhedged portfolios they acquired directly from the Treasury at auction. This means most of the $55 billion that was transferred by the public to the Fed will be transferred by the Fed to the dealers, who may then deploy it as they wish. This money may or may not enter the economy, as it could simply lay fallow as excess reserves at the Fed. Or, it could be funneled into proprietary trade positions, such as equities (as we saw in the second and third quarters of 2009), derivatives, precious metals, or more Treasurys.

Seldom is either deflation or inflation omnipresent in an economy. Despite the ongoing consumer and bank deleveraging, large amounts of free money will always look for a market in which to bid up prices. Will $55 billion a year be enough to inflate a particular market or sector of the economy? Maybe, maybe not. However, it is inevitable that at some point in the future we will return to crisis mode to an extent that will goad policymakers into demanding a much larger amount of printing. As there is no end in sight to mammoth deficit spending, that time will not be the last either. Accordingly, the risk of money printing overshoot with resulting across-the-board inflation is real and should not be ignored.